How To Calculate Opportunity Cost: Making Better Choices Using Basic Economics

Opportunity Cost is an economic concept referring to the sacrifices made when a choice is made from any given set of options. To use a classic example from introductory economics: If a farmer decides to use his field to graze 50 cattle instead of growing 100 bags of wheat, his opportunity cost is 100 bags of wheat.

The application of this concept on our daily lives is very interesting, because humans do not exist purely to produce goods or earn money. We have much more abstract needs and wants that each individual places different value on. 100 bags of wheat is worth the same thing to every farm, but every individual will place a different value on (for example) having a romantic partner – to some, it may be the primary focus of their lives, and at the opposite end of the scale some may actively avoid a romantic relationship.

It’s also interesting that time is a much more valuable resource to us as humans than to businesses producing goods. We have a finite amount of time on the earth, whereas a business’s time is unlimited. It can outlive its staff and, in theory, continue operating infinitely. If it wants to produce more goods, it can usually hire more staff or buy more equipment to scale up. It is limited only by its finances. On the other hand, humans cannot use money to increase their “production” of happiness, health, knowledge, etc – and so we are limited by the finite nature of time, rather than money, which is a renewable resource. If we need more money, we can do more work, sell belongings, or wait until next paycheque.

Time is not only finite, but it is also linear. Where money is concerned, we can always bring our bank balance back to the figure prior to a purchase. But in terms of time, we cannot “go back” to one month ago. That means the choice to forego an opportunity do something unique (such as a job offer, watching your child’s school play, or approaching an attractive stranger in a bar) is permanent. It pays to be able to recognize whether an opportunity is unique or not – for example, consider an 18-year-old facing the choice between traveling or starting university studies. The opportunity to travel is much more unique in that situation. Though they likely will be able to travel at many other points in their life, they are unlikely to ever have so few responsibilities (e.g. mortgage, spouse, children) or such a good resistance to hangovers. Conversely, their university degree will probably be exactly the same regardless of when they begin studying. This doesn’t mean that traveling is the “correct” decision – we still need to consider the opportunity costs – but the fact that the opportunity to travel is more unique than the choice to study should be considered in our decision making process.

Every day we are forced to make many choices, and with every single choice there is an opportunity cost.

A freelancer who decides to go over to a friend’s house for a two hour lunch instead of working has an opportunity cost of two hours’ earnings. This is fairly simple to calculate, and can be directly quantified financially. Conversely, if they choose to work for two hours, their opportunity cost is a bit more complex. They forego things such as the enjoyment of spending time with a friend, the health benefits of socializing instead of working in isolation, potentially the strength of the relationship with the friend, and of course the financial value of a free lunch.

In order to better quantify the value of certain choices, it’s helpful to calculate your true hourly income after tax. Get your last pay slip, and then subtract any expenses incurred in order to earn that money – i.e. transport costs, uniforms, etc. Then divide that figure by the number of hours spent on work-related activities during that period. Remember to include time traveling to and from work, work-related events outside of normal hours, etc. This figure is your true hourly income.

This allows you to think of financial costs (renewable resource) in terms of time (finite resource). For example, if your true hourly income is $20, you can ask yourself if a new pair of $200 shoes is worth 10 hours’ work. Even more interestingly, though, we can now calculate the opportunity cost of buying the shoes in terms of both time and money. The $200 could be spent on a fantastic dinner for two at a restaurant, or the 10 hours spent working could be spent on time with the family.

This also allows you to quantify, in financial terms, any time spent on a given activity. For example, is watching a two hour movie really worth two hours’ income? You can even compare these quantified gains with hypothetical happiness gains. Would the $200 spent on shoes in the previous example bring more happiness than watching 10 hours of TV? Would a $200 dinner with your partner bring more joy than spending 10 hours with your kids?

Opportunity costs as they pertain to one’s health are also interesting. For example, eating cheaper, less healthy food may have a lower financial cost, but it presents interesting opportunity costs in other areas. You may have to spend more time on exercise to maintain a healthy body weight, have less energy, incur future medical costs, or even shorten your lifespan.

So let’s tie this all together into a practical situation. Consider the choice between going on a weekend trip away with friends versus staying home to study.

If we choose to stay at home we sacrifice a unique opportunity to go to that specific place with that specific group of people. We also incur the emotional cost of not socialising, and by missing the opportunity to see these friends we may lose touch with them.

Conversely, if we choose to go on the trip away, we incur financial costs. We should calculate the opportunity cost as the difference between what we would have spent over the weekend at home versus the cost of the weekend away. By going on the trip we forego the opportunity to study – which costs us knowledge (and potentially further costs if we fail an exam). We may also incur costs on our health from unhealthy food and alcohol.

There is no “right choice” from the above. Nobody can help you assign value to things like knowledge gained from studying, or the emotional benefit of socializing. But hopefully by thinking more deeply about the opportunity costs of your choices and having the ability to quantify money and time in like terms, you will find yourself making more well-informed decisions and maximizing your finite time on this earth.